How to Treat Unearned Revenue when Setting Net Working Capital Targets
In a previous blog article entitled, A Practical Approach to Setting Net Working Capital Targets, we looked at some practical considerations for setting a Net Working Capital (NWC) target when the monthly financial information is less than perfect. We also stated that, for businesses with a significant unearned revenue component, the negotiations over its treatment can be complicated and would be the subject of a future blog post. The purpose of this article is to discuss that issue.
In a business acquisition, the purchaser expects the vendor to provide (at the closing date) all the assets necessary to operate the business at the anticipated level of activity that produces the expected cash flow assumed in the agreed enterprise valuation. These assets include NWC, fixed assets and intangible assets.
A key step in negotiating the purchase price for a business is for the parties to agree to a normalized level of NWC known as the NWC Target. The actual level of NWC transferred at the closing date is then compared to the agreed NWC Target. Any excess NWC would be added to the purchase price, and any shortfall would be deducted, often on a dollar-for-dollar basis.
COMPONENTS OF NWC
NWC, for accounting purposes, is defined as all current assets minus current liabilities. However, for valuation and deal pricing purposes, NWC includes only current “operating” assets and liabilities.
Operating assets typically include:
- Accounts receivable: Receivables may include amounts owed by customers for:
- Goods or services already provided by the company, for which the associated revenues have been earned; and
- Goods or services which the customer has committed to purchasing but have not yet been provided by the company and for which the company has recorded an unearned revenue liability.
- Inventory: Amounts spent on goods purchased or manufactured and held for sale.
- Prepaid expenses: Prepaid expenses reflect amounts paid by the company in advance of using the related services.
Operating liabilities provide a continuous source of trade financing for a business and might include:
- Accounts payable and accrued liabilities: This represents amounts owing to trade suppliers and other creditors for goods and services provided to the company on credit;
- Unearned revenue: This represents amounts paid to the company for goods or services that have not yet been provided to the customer at the reporting date. Recognition of the revenue has been deferred until a future period when the goods or services have been provided. An example might be the payment of tuition fees to a school at the start of a school year.
A CLOSER LOOK AT UNEARNED REVENUE
Unearned revenue represents a future obligation to provide goods or services. Conceptually, the amount of unearned revenue includes both a “cost of delivery” component and an “operating profit” component. For this reason, unearned revenue will often be the cause of significant debate on every transaction where it is encountered.
As with all credit balances on the balance sheet:
- Sellers will prefer to treat an unearned revenue liability as a “working capital-like item” (i.e. similar to accounts payable). The effect would be to reduce the amount of the NWC required at closing.
- Buyers would prefer to include unearned revenue as a “debt-like item” since outstanding debts are subtracted from business enterprise value in arriving at the price paid for the shares.
The rationale that a buyer will use to justify including unearned revenue as a debt-like item is that the balance represents a liability for services to be provided post-closing for which the seller has received the related cash (and for which the buyer will pay on a dollar-for-dollar basis).
Conversely, sellers will argue that unearned revenue is merely a timing difference, which would only materialize as an absolute liability in the event the business is wound up. Future draw-downs of the unearned revenue liability (when the goods or services are provided) will be replaced with fresh funding provided by new customers. As such, the balance should be treated as a component of working capital.
One issue to consider is whether the unearned revenue was created by the receipt of cash or by booking a trade receivable. If no cash has been received in advance of providing the associated service, the purchaser will be hard-pressed to claim unearned revenue as a debt.
Another consideration is the stability of the unearned revenue liability throughout the operating cycle. If the balance remains stable throughout the year, this suggests unearned revenues are only a timing difference, whereby cash receipts received are used to fund the costs of providing the current service (a working capital item). This contrasts with a gradual draw-down of the liability over the cycle, suggesting the unearned revenue liability is more like a debt that needs to be repaid.
It can often be helpful to consult with market participants in a specific industry. For example, in the education and training industry, large tuition fee deposits are received before the semester starts. Since there are significant future costs associated with providing the training services, and a purchaser may want to see unearned revenue treated as a debt. However, discussion with a school operator might reveal that significant recruiting expenditures are made in advance to secure those enrolments. Therefore, it might be more reasonable to reduce the debt by an amount equal to the advance costs incurred by the school, plus a reasonable profit margin.
Treatment of unearned revenue as a working capital item may imply that the company can operate comfortably with negative operating working capital. A review of historical monthly working capital balances may show this to be the case for several years.
The treatment of unearned revenue liabilities as working capital can result in a substantial reduction to the company’s operating assets. This might have important implications for a purchaser’s assessment of risk. For example, a purchaser may use this additional risk as pretext to justify applying a lower earnings multiple in the pricing analysis.
An important takeaway is that the treatment of an unearned revenue liability is a process of negotiation. There is no clear answer one way or another. In some cases, we have seen the seller agree to treat the cost component of unearned revenue as a debt but share the profit component with the purchaser.
For more information about this topic, or if you would like to discuss your individual situation, please contact our Director of Valuation Services, Paul Woodhouse, directly or fill out our Get in Touch form and one of our M&A Advisors will reach out to you.